The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Sunday, July 28, 2013

Truth of transparency and liquidity

In an excellent column, Dan Collins looks at a study done on the CFTC's Swaps Execution Facilities rules and finds that the biases of the different market participants drive their responses.

For example, he finds that Wall Street objects to transparency and prefers opaque, over the counter markets.

Please note, this study only looks at one form of transparency: pricing transparency. There is a second, much more important form of transparency: valuation transparency.

To understand the relationship between the two forms of transparency, it is necessary to look at the investment process that separates investing from gambling.

Independent assessment of all the useful, relevant information about an investment by market participants so they can understand the risk of and value the investment. Doing this assessment requires valuation transparency.

Comparing the independent valuation to the price shown by Wall Street to make a buy, sell or hold portfolio management decision.

In the absence of valuation transparency, it is impossible to complete Step 1 of the investment process. Simply buying or selling based on prices shown by Wall Street without having completed Step 1 is gambling on the contents of brown paper bag.

When it comes to liquidity in a market, markets with transparency are naturally more liquid as there are more investors than there are gamblers.

Mr. Collins also finds in the CFTC study that Wall Street objects to transparency claiming it will reduce liquidity. A claim that he thoroughly debunks.

The whole point of the Dodd Frank Act as it relates to swaps was to move this opaque over-the-counter trading on exchange or at least into a clearinghouse and executed through an electronic facility so there is a clear and transparent paper trail....

It is too early to tell if the CFTC got it right and the results of the study correctly point out that its respondents based their responses on their self-interest. For example, of the respondents that think the CFTC did not go far enough, 90% said there were “too many holes” in the rules; of the respondents who though the CFTC went too far , 92% said rules had “excessive transparency.”

The report states “Reasons for discontent are broad and contradictory — ranging from those who feel the final rules are prone to gaming, to those who think excessive transparency will damage liquidity.”

There is a lot to take in here but let’s hone in on the above statement: “excessive transparency will damage liquidity.”

This sounds counterintuitive. How can seeing more prices and quotes harm liquidity?

Transparency should always help liquidity unless what that transparency shows is a gamed market.

Transparency provides confidence that a counterparty can see definitively where price is at in a particular market and how liquid the market is so he knows his risk.

When the Chicago Board of Trade launched interest rate futures in the late 1970s it harmed the liquidity in the cash treasury market because end users could all of a sudden access a more efficient market with narrower bid/ask spreads.

It is not nearly as complex as the investment banking lobbyists would have you believe. It is about competition.

Just think of shopping for a car and going into a dealership where the salesman offers you the sticker price. Now imagine that you can go online and see every price that this car is offered at in a competitive marketplace.

The fact that this has been such a struggle is testament to the lobbying efforts of the major investment banks who have basically been able to run a rigged game....

We pointed out recently the irony that the same folks who berated the industry and regulators over making the regulated futures world more transparent with electronic trading have fought that same transparency in the OTC markets they controlled.

As I mentioned above, it is not that complicated.

In fact it is simple; excessive transparency will hurt the liquidity of an inefficient market but help the liquidity of a more efficient market.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.